Lesson 72 – The Global Financial Crisis of 2008-2011 – Part One – Essentials and Prologue

The financial crisis that erupted in the fall of 2008 with the collapse of Lehman Brothers (an investment

bank) in New York started a painful process of financial de-leveraging (debt reduction) that will destroy

trillions of dollars of assets either in a short, sharp and very painful recession or over years of stagnant

growth and falling incomes. The next four lessons will attempt to tell you what this financial crisis is all

about, how we got to this point, and where it is likely events will unfold from here.

The financial crisis is often presented as just another recession, similar to other recessions which, as we

know, are an integral part of the business cycle (as we discussed in lesson 42). However, in scale and in

form, this crisis is much more serious than other recent recessions as it is leading to a crisis of

confidence that is afflicting not just firms, not just industries, not just institutions, but the entire global

monetary and financial system. As we learned when studying microeconomics, markets, by generating

accurate price information, lead to the efficient allocation of society’s scarce resources. As we also

learned earlier, market economies do not arise spontaneously – rather they are built upon trust and

confidence. We take risks, we borrow, and we lend, not because we trust the people with whom we are

dealing, but because we trust the system and the laws and the institutions that govern us.

This present crisis, though, threatens both of these pillars of the market economy. In a remarkably

vicious feedback loop, markets have become increasingly distorted through the intervention of

established governmental and financial interests, which has led to a gross misallocation of resources

towards the financial and other associated sectors of the economy. As this misallocation has intensified,

so too have the market’s underpinnings in law and institutional integrity become weaker. Rather than

accept the losses resulting from their misallocation of investment capital into real estate and

speculation, the financial industry has instead become increasingly good at lobbying government for bail

outs, low (or zero) interest loans, and favourable legislation. This ‘regulatory capture’ of government by

the financial industry has in turn led to markets becoming increasingly unable to generate accurate price

information that would permit efficient resource allocation. The millions of unemployed and hundreds

of thousands of abandoned homes across the US and much of the world constitute unambiguous

evidence that the economy is out of whack. Increasingly desperate efforts to re-inflate asset prices with

ultra-low interest rates, meanwhile, only make the fundamental problem of excessive debt even worse,

which uncorrected over time can only lead to a complete loss of confidence and utter collapse.

We experienced a similar set of circumstances in the 1970s, and it is useful to look at that crisis and its

eventual resolution to throw some light on current events. At the Bretton Woods conference towards

the end of WWII (with Keynes involved), countries agreed to a global monetary system that had, at its

centre, the US dollar. The US dollar was given this central role as the US economy was the largest in the

world, and as the rest of the world desperately needed the resources and goods of the US to rebuild

after the war. As well, the US had the world’s largest gold reserves, and foreign central banks holding

dollars as reserves were allowed to, at any time, exchange their dollar reserves for gold at a price of $35

per ounce, making the dollar literally ‘good as gold’. The values of all other currencies were fixed against

the dollar, and the International Monetary Fund was created to both offer emergency loans and

prescribe structural reforms to countries facing persistent balance of payments deficits.

This system worked well until the late 1960s (see lesson 57) when spiralling US spending (to support

both the war in Vietnam and domestic social programs) and rapid growth in the US money supply led to

higher inflation, which in turn caused some foreign holders of US dollars to lose confidence in the dollar

as a store of value and to begin to demand gold. As the quantity of dollars circulating worldwide by now

exceeded (by a large factor) the quantity of gold reserves held by the US, in 1971 the US government

‘closed the gold window’ and refused to honour requests from foreign central banks to exchange their

dollars for gold. The dollar was now a purely ‘fiat’ (ie un-backed by an asset like gold) currency.

Partly as a result of this, inflation accelerated throughout the 1970s and by the end of the decade was

comfortably in the teens in most industrialized economies. Commodity prices were skyrocketing and

many ordinary people were becoming increasingly impoverished due to ever-rising prices for food and

fuel and rising unemployment (ie ‘stagflation’) even as real estate and commodity speculators grew

wealthy. Gold reached a high of almost $900 an ounce as people fled paper money (which, due to ever

higher inflation was an increasingly poor store of value) for the safety of ‘hard money’.

Faced with this economic wreckage, US President Jimmy Carter appointed Paul Volcker head of the U.S.

Federal Reserve in 1979. Volcker recognized that inflation was destroying the US economy and he was

determined to bring it down. In order to do so, he raised interest rates (which, in the inflationary 1970s,

had often been less than the rate of inflation) until rates were over 20%. Such high rates destroyed the

fortunes of speculators (such as Donald Trump in the US and Peter Pocklington in Canada), who found

that they could neither sell the assets they held (as people were unwilling to borrow money at such high

rates to buy them) nor service the debts that had taken on to buy them. Many prudent businessmen,

farmers and households also suffered as they were similarly unable to service their business or housing

loans. Overall, while asset prices fell sharply, the high interest rates did restore faith in the monetary

system as people were once again willing to save with money, as opposed to property or metal.

Further, people around the world once again trusted the United States and US dollar denominated

assets governed by US securities laws. Not just the US, but indeed the entire world, benefited from

Volcker’s determined slaying of the dragon of inflation.

The next year, 1980, saw the election of Ronald Reagan to the White House. While Reagan supported

Volcker’s policy of high interest rates to tame inflation, he at the same time sought to ameliorate the

pain caused by such high rates by pursuing pro-growth fiscal and regulatory policies. Reagan’s tax cuts

(mainly for the wealthy – the top income tax rate was cut from 70% to 28%) and spending increases

(mainly for the military) were meant to stimulate spending, investment and employment, while

deregulation (of the airline, trucking, and financial industries) was pursued to improve efficiency and

competitiveness, which would, it was hoped, both increase output and employment and reduce prices.

In general, the combination of tight monetary policy, loose fiscal policy, and supply-side deregulation

worked, and by 1982 the economy was growing. However, the deregulation of the financial industry was

to have far-reaching unintended consequences.

Exercise 72

1. Using the diagrams below (which you should fully label) explain and show the impact of, in turn:

a) The increases in interest rates under Paul Volcker upon the US economy and the US dollar

b) Reagan’s tax cuts and spending increases upon the US economy

c) Reagan’s deregulatory policy upon the US economy

2. Distorted prices can be thought of as lies. While a good or service may be actually worth $X,

uncompetitive or manipulated markets may lead to the price being $Y. Reflect that if you lie,

you are tempted to continue to lie ever more extravagantly to cover up your initial lie so as to

keep the confidence of your friends and family. What do you think governments are tempted to

do to ‘restore confidence’ when competitive markets begin to expose a pricing ‘lie’?

Lesson 73 – The Global Financial Crisis of 2008-2011 - Part Two - The Years of Confidence

Volcker’s success in taming inflation and restoring the US dollar to its position as the global reserve

currency and by extension the global monetary and financial system to health yielded enormous

benefits in the years to come. People had confidence in the dollar and in the US economy, and as a

result people around the world increasingly invested their surplus money in the US stock market and

other assets. These inflows of capital looking for a safe haven made it easy for the US government to

borrow as foreigners (and foreign governments and central banks) were happy to buy US government

bonds. As well, companies found it easy to raise money on the New York Stock Exchange, as not just US,

but global investors were eager to place their bets on the US economy. This easy availability of capital

fuelled a great deal of innovation in, among other places, Silicon Valley, and gave rise to many of the

companies that created today’s online world.

As well, once policymakers were satisfied that inflation was no longer a threat, interest rates (including

bond yields) began to fall. This was immensely beneficial to the stock market for a number of reasons.

First, companies, which tend to be net borrowers, faced lower interest costs and therefore enjoyed

higher profits, boosting stock prices. Second, consumers began to borrow and spend again, which again

boosted company sales, profits and share values. Third, savers facing lower interest rates on bank

deposits and bonds while seeing stocks rising in value began to invest in the stock market. Up until the

1980s, very few individuals invested in the stock market, but as the 1980s wore on, having a stock

portfolio (or at least units in a mutual fund or unit trust) became more and more common.

These increased flows of capital into the stock market proved to be a bonanza for the recently

deregulated financial industry. As other governments around the world also embraced deregulation (ie

the “Big Bang” that liberalized the London Stock Exchange and kept London the most important financial

centre in Europe), bankers and financiers began to pursue innovative trading strategies (usually

developed with the aid of sophisticated computer models) that promised high returns and diminished

risk. Two developments in particular are worth mentioning.

First, financial deregulation allowed banks to increase what is called ‘leverage’. Leverage occurs when

you borrow most of the value of the assets you buy and hold. For instance, most homes are leveraged –

you put 20% down and borrow the remaining 80% in the form of a mortgage. If the house goes up in

value by just 20%, you have, after paying back the loan, doubled your money. Investment banks

(Goldman Sachs, Lehman Brothers, Bear Stearns, JP Morgan) were very keen to increase their leverage

as it would amplify their profits in an environment of rising stock and asset prices.

Second, the market in what are called derivatives was kept unregulated even as the value of derivatives

traded grew astronomically. A derivative is simply an asset that takes its value from another underlying

asset. For instance, oil is traded as a commodity. Refiners buy oil from oil companies. This market for oil

establishes a price for oil on what is called the spot market. However, dwarfing the trade on the spot

market is the trade in oil on the futures market, where traders buy and sell contracts for oil to be

delivered in the future. While futures markets can help refiners and sellers lock in prices now for later,

and thereby avoid uncertainty (this is called hedging), most futures contracts are traded by speculators

who have no interest in either selling or buying the actual physical commodity in question. Instead, the

speculators (who can serve an important market-making function) are looking to make money on the

contracts themselves. For instance, if oil were trading now for $100 a barrel and if people did not expect

the price to change much into the future, I could likely purchase a contract to buy oil in 3 months for

$100 a barrel relatively cheaply. This contract is a futures contract, and it is a derivative of the oil

market. Now, if oil prices rose to, say, $120 over the next 3 months, I would be very happy, because I

have a contract that allows me to buy oil for just $100. The contract is now worth about $20. By selling

the contract to someone else I can make a tidy profit. Note that at no time was I actually buying and

selling oil – instead I was buying and selling contracts to buy and sell oil. Over time, derivatives

(contracts or options) were created for every commodity and most other financial assets as well.

However, while in general the falling interest rates of the 1980s and 1990s led to a stock market boom,

there were hiccups on the way. First of all, in 1987, computerized trading systems responded to a small

fall in stock prices with further selling, leading to the largest ever single day percentage drop (over 22%)

in the Dow Jones Industrial Average (a measure of the value of the overall stock market).

More seriously, in the late 1980s a number of cooperative banks in the US (known there as ‘Savings and

Loans’) went bankrupt. Prior to deregulation in 1980, the S&Ls were simple institutions designed to take

deposits from and make loans to their members. However, after deregulation, they were empowered to

engage in riskier loans and investments. Unsurprisingly, many S&Ls ended up making bad loans to

relatives and friends. However, while cleaning up the mess (ie guaranteeing the deposits of S&L

members under a program similar to the Federal Deposit Insurance Corporation) cost the US taxpayer

billions of dollars, the integrity of the system was upheld as hundreds of directors of the bankrupted

S&Ls were convicted of racketeering and fraud.

While there was a recession in 1991 (caused at least in part by higher oil prices in the wake of Iraq’s

conquest of Kuwait in the summer of 1990 and the subsequent ‘First Gulf War’ in which the US (and

coalition allies) drove the Iraqis back to Iraq), by the middle of the 1990s many people thought that the

business cycle of boom and bust had been tamed. Alan Greenspan, who had succeeded Paul Volcker as

Federal Reserve chairman in 1987, was nicknamed ‘the maestro’ for his supposed ability to magically

restore confidence to sometimes jittery markets.

Under Greenspan’s leadership, though, the global financial system increasingly came to depend on the

US Federal Reserve to lower interest rates and enact bailouts when risks turned sour. The problem with

such intervention is that while it does restore calm and confidence and avoids pain in the short term, in

the long term it creates what is called moral hazard. Moral hazard occurs whenever the party or

individual making decisions is not made to suffer the full consequences of their actions and choices. For

instance, parents seeking to avoid moral hazard will threaten their children that if they decide to

become artists, that they should not come back asking them for money. Of course, most kids know that

if they are hungry that their parents will shelter and feed them. Nonetheless, even a semi-credible

threat will often be enough to direct them to pursue self-sustaining careers. Those parents whose

threats are not so credible suffer the consequences of moral hazard when their kids return to stay.

So, when investors in Mexican government bonds faced potential losses during the “Peso Crisis” of

1994, the US pledged a $50 billion bailout to the Mexican government. This support gave investors

confidence that the Mexican government would be able to honour the bonds (A bond is simply a

promise to pay. In exchange for giving the Mexican government a certain sum of money, the Mexican

government had promised to pay a higher sum back in the future). As a result, bondholders did not

panic and sell their bonds and the crises eased, and Mexico was easily able to pay back the money

advanced by the US.

In 1997/1998, a series of financial crises roiled across smaller nations, especially in SE Asia. Global

investors expected the US to respond. When they did not, as in Thailand, the loss of confidence often

spread to other neighbouring nations. In the increasingly interconnected world of global finance, fears

of ‘contagion’, or of a small crisis in one place leading to ever-larger crises in other places made it seem

imperative that policymakers respond quickly to events to maintain confidence.

People in nations like Thailand, though, often felt as though they had been tricked by the financial

deregulation that the US had encouraged them to undertake. Before the 1990s, many of the nations

which subsequently suffered through the 1997 Asian financial crisis had very tightly regulated banking

sectors that faced very little or no competition from foreign banks. When these nations did deregulate,

large international banks entered the market and flooded the country with loans. As time went on,

many of these loans, predictably, went to fund projects (especially in real estate development) that

were unlikely to be successful. Inevitably, investors lost confidence and foreign capital took flight,

prompting the IMF to orchestrate a bailout. However, while the bailouts guaranteed the foreign banks

and bond-holders their money, the conditions of the bailouts were usually cuts in government spending

and subsidies to the poor as called for under what were termed ‘structural adjustment programs’.

Fundamentally, people in SE Asia (and Argentina later in the early 2000s) felt that they had been lured

into taking loans which they could not afford (but which had financed a glorious period of rapid income

growth and development) only to lose their sovereignty in exchange for bailouts which only protected

the interests of foreign banks and bondholders.

However, as a consequence of this increased willingness by the US (often through the IMF) to quell

crises with bailouts, investors began to increasingly discount risk. Moral hazard was affecting the

decisions of bankers and investors. If a risky investment anywhere was offering fat returns, banks and

investors felt increasingly confident that they would be free to enjoy the returns and that, if the risks

became apparent, the US government, through either the Federal Reserve or the IMF, would act to

correct things. Unsurprisingly, confident that they would never have to bear any losses if risks turned

sour, banks and investors sought out increasingly risky assets with correspondingly high returns.

Overall, falling interest rates and deregulation had led to increased borrowing and investment, and had

therefore fuelled growth, but beneath the shiny surface, the risks posed by increased leverage, the

expansion in the quantity and variety of derivatives traded, and from moral hazard were growing.

Exercise 73

1. Define:

a) LEVERAGE

b) DERIVATIVES

c) MORAL HAZARD

2. Why would interest rates fall as inflation fell in the 1980s?

3. Imagine you are an investment bank, and that you are leveraged 30 to 1. That is, for every dollar

of the bank’s money invested, there are 30 dollars of borrowed money invested. Imagine that

the bank buys a stock at $31 per share. Assuming no interest on the money the bank borrowed,

if the stock went to $32 per share, after paying back the borrowed money:

a) How much money does the bank have left over?

b) How much of that money is profit?

c) What percentage is this profit of the bank’s initial investment?

d) What would have happened to the bank’s investment had the share gone to $30?

4. Imagine that you are again an investment bank, and that you are now trading derivatives

contracts, specifically options, which give you the right, but not the obligation, to buy a

commodity at a certain price on a certain date in the future. You buy a contract to buy gold at

$1600 per ounce (the same price it is now) in 6 months, and this contract costs you $10.

a) If, on the options expiry date (ie in 6 months time) the gold price is $1650 per ounce, how

much should your contract be worth?

b) How much profit did you make on the contract? What percentage profit did you make on

your initial investment?

c) What would have happened to the value of your option if the price of gold had been below

$1600 on the expiry date?

d) Now, redo ‘b’, but imagine that you had bought the options contract with leverage, so that

you borrowed $9 of the cost of the contract and only used $1 of your own money. Assuming no

interest on the money you borrowed, what would be your percentage profit now?

Lesson 74 – The Global Financial Crisis of 2008-2011 - Part Three - Enter Fraud

When the bank robber Willie Sutton was asked by a reporter why he robbed banks, he reputedly replied

“because that’s where the money is.” Similarly, as the financial markets became increasingly where the

money was in the late 1990s and 2000s, so also did they become increasingly the platform for fraud.

The “cult of equities” (aka stocks) reached a fever pitch in the late 1990s during the dotcom bubble. By

the end of the decade financial news was on the front page and everyone, rich and poor, was excited by

technology companies whose stocks, despite often having no earnings, nonetheless rose steadily in

value on the NASDAQ stock exchange. In a nice touch, information technology enabled people to invest

in technology stocks without having to go through a broker so long as they had a computer, a modem,

and an electronic brokerage account.

With money flooding into the stock market, and with the media increasingly infatuated with the

financial markets they were supposed to be monitoring, what Alan Greenspan famously called

“irrational exuberance” took hold. For a while, it was a virtuous circle, as the money flooding in

supported higher prices, and earned many people who had gotten into the market for technology stocks

in the mid-1990s vast sums of money. However, in the end, the dotcom bubble became a Ponzi scheme.

A Ponzi scheme (or pyramid scheme) is so named for the fraud perpetrated by Charles Ponzi in the

1920s, where investors are encouraged to invest with promises of high returns which come, in the end,

from the money contributed by later investors. During the dotcom boom, investors made money buying

over-valued technology stocks as long as there were ‘bigger fools’ willing to pay even more later on.

The 2001 collapse of the energy trading firm Enron, which had been a darling of the financial media and

whose spectacular profits and rapidly rising stock price had lured in many investors, was a wake-up call

to some of the excesses of the financial industry. While retail investors were buying stocks in what was

purportedly a wonderfully profitable company, company insiders, aware of the true condition of the

firm, were selling. What was most disturbing about the Enron story was the revelation that it had

engaged in massive accounting fraud, aided and abetted by the accounting firm Arthur Andersen. Enron

employed a dizzying array of accounting tricks to keep profits on its books while putting losses onto the

books of subsidiaries (ie off-balance sheet accounting) registered in offshore banking centres. However,

in order not to lose lucrative consulting contracts with the firm, Arthur Andersen’s auditors (ie the

people who check the accounts of companies to make sure they are in accordance with the law) did not

look too closely at irregularities which even business school students found suspicious in the course of

their case studies. The exposure of this, and other scandals in the early 2000s shook confidence in the

stock market, which, like any other market, depends upon trust. Investors felt, quite rightly, that their

trust had been violated and began to pull their money out of.

As a result of this, in 2001 the US economy slipped into a recession. As there had been a lot of

misdirected investment in previous years a recession was what was needed to reset prices and redirect

investment capital towards other productive sectors. However, in the wake of the 9/11 attacks, it was

decided that the last thing American needed was a recession. Famously, President G.W. Bush exhorted

people to go out and shop in response to the attacks to show the terrorists that Americans would not let

them affect their way of life. As a result, the Federal Reserve lowered interest rates steadily until they

reached just 1% in 2004. Global trade imbalances, in particular those between East Asia (mainly China)

and the US, also helped to keep US interest rates low (as was discussed in lesson 69).

As we discussed in lesson 39, though, ultra low interest rates can result in precious capital being

misallocated. In many countries, low rates led to a frenzy of home building and buying, and a significant

increase in real estate prices. For a time, growth in the housing sector became self-sustaining, and

contributed significantly to economic growth as people used the increase in the value of their homes as

collateral for loans to finance increased spending. In short, rising asset prices supported increased

borrowing which in turn supported increased consumption and therefore GDP.

Banks were eager to profit from rising real estate prices and so (in line with the tendency to create and

trade derivatives) increasingly securitized mortgages to sell to investors. This process of securitization,

though, became corrupt. In the old days, when a homeowner took out a mortgage from a bank, the

bank would keep that mortgage on its accounts as an asset and so was concerned that the asset be a

good one. In other words, as mortgages granted were owed to the bank, the bank would only grant

mortgages to lenders clearly capable of paying them back. Securitization changed all of this. The process

of securitization was as follows. First, a mortgage broker would grant a mortgage to a homebuyer. The

mortgage broker was paid a commission that was based on the type and value of mortgage sold.

Mortgages to riskier homeowners (those with few assets or with a spotty employment and income

record) often could command higher interest rates and would often net the brokers a better

commission. The mortgages then were passed to the bank that issued the money, which would in turn

pass the mortgages on to an investment bank which would then create what was called a ‘mortgage

backed security’. Investors (pension funds, municipalities etc.) who bought mortgage backed securities

(which were sold as ‘low risk) would then receive the mortgage payments from the homeowners.

The problem with this approach was that the people who ultimately held the mortgages were not the

same people who had approved the mortgages. Mortgage brokers were interested in simply awarding

as many mortgages as possible and collecting their commission, while the banks, knowing that they

would in turn pass the mortgages on to investors, also were not motivated to ensure that the people

being granted mortgages were likely to pay them back. Predictably, some people who were granted

mortgages in this way (which often featured sharply rising rates a couple of years in, at least partly due

to the Federal Reserve’s decision to start raising interest rates in 2005 to arrest what was obviously a

housing bubble) later on proved unable to make their payments.

As these ‘sub-prime’ (ie high risk) mortgages went into default, two things happened. First, the homes of

the people in default were repossessed and were sold. This increase in housing supply had the effect of

driving down real estate prices, which led to some other homeowners owing more on their mortgage

than their home was worth. In this situation, many people who were able to make their payments

decided they would be better off walking away from their homes and associated mortgages, which

further increased the supply of homes on the market, further depressing prices in a vicious circle.

Secondly, investors who had bought mortgage backed securities stopped receiving the payments that

they had been assured were guaranteed. As the assumption had been that house prices would always

rise, the ratings agencies had judged such securities to be very safe. Now that they were shown to be

risky, a crisis of confidence swept the financial world. Most banks held mortgage backed securities in

their portfolios and up until the middle of 2008, they were a heavily traded liquid asset. However, once

they were seen as potentially risky, banks rushed to dump their mortgage backed securities and sought

the safety of cash. This collapsed their value and led to, among other things, the collapse of Lehman

Brothers in the fall of 2008. This collapse led financial markets to grind to a complete halt as Lehman

Brothers had assets and debts with most other large financial institutions who were now also potentially

in financial trouble if their money held with Lehman turned out to be unrecoverable.

To unfreeze capital markets, the US Treasury and the Federal Reserve agreed to buy up ‘troubled’ assets

(ie worthless mortgage backed securities) at full face value and to enable banks to borrow essentially

unlimited amounts of money at very low (almost zero percent) interest rates. This had the desired effect

on the financial system, and once again banks began to borrow and lend.

However, these bank bailouts (which were undertaken in concert with other governments around the

world) expanded government debt and increased the money supply enormously. While they restored

confidence in the financial system, they did so at the expense of confidence in the ability of

governments to pay their debts (ie the European debt crisis) or protect the purchasing power of their

currencies. More ominously, the bailouts were not accompanied by regulatory or other reforms

designed to reduce the ability of the banks to engage in risky, over-leveraged speculation in derivatives

and other assets. In fact, the bailouts, in the view of many commentators such as Matt Taibbi at Rolling

Stone Magazine, may have just encouraged more financial crises in the future due to moral hazard.

The fact of the matter is that the global financial system remains highly leveraged, and that the banks

themselves are not likely to voluntarily deleverage themselves as they are addicted to the profits that

can be made from leverage, particularly when they can borrow money at no cost from central banks.

Fundamentally, ultra-low interest rates can be seen to be enabling the financial industry to continue to

operate in the same fashion that brought on the crisis in the first place.

The collapse of the commodities broker MF Global in November 2011 was caused by a highly leveraged

trade on European bond derivatives that went wrong. However, MF Global had pledged assets in the

accounts of its customers as collateral for loans it had taken to make the trade. The financial industry

calls this practice, legal in the UK and the US, “re-hypothecation.” To make an analogy, when I take out

a mortgage on a home, I pledge the home as collateral against the loan. If I can’t pay back the loan, then

the lender has the right to take my home. However, no one else is allowed to use my house as collateral

for their loans. Otherwise, other people would gladly take out loans against my home secure in the

knowledge that if they couldn’t pay them back, that it is I who would be made homeless. However,

people with accounts at MF Global have seen the assets in their personal accounts seized by the banks

(JP Morgan is one) which lent MF Global money for its trades, as these assets had been pledged as

collateral for the banks’ loans to MF Global. The details of the bankruptcy are causing investors to lose

confidence in the US financial system’s institutional integrity and commitment to the rule of law.

Exercise 74

1. Define:

a) PONZI SCHEME

b) SECURITIZATION

c) RE-HYPOTHECATION

2. You live in a big city. You tell three of your friends about an investment opportunity you can that

is too complicated to explain, but that they must trust is real, that can give a return of 50% a

month. You tell them that you can only let in a few other people on this great opportunity, and

so they can only bring in three other people. All you ask is for them to give you $1000.

a) Complete the table below to see how the scheme would progress if repeated 4 times before

it collapses. Every round lasts one month. People only get paid their return (50% of $1000 =

$500/month) after they have been involved for at least a month.

Round New Participants Payments Received Old Participants Payments Disbursed

1 3 3000 0 0

2 9 9000 3 1500

3

4

End Total: Total:

b) What was your ‘take’ (payments minus disbursements) on the Ponzi scheme above?

c) Who else won from the scheme? Who lost?

3. We saw how the accounting firm Arthur Andersen failed to perform proper audits on the

accounts of Enron. Similarly, ratings agencies (like Moody’s and Standard and Poors) gave

mortgage backed securities “AAA” ratings as very safe investments, which encouraged pension

funds and others to buy them. Lastly, the trades undertake by MF Global were approved by the

Commodity Futures Trading Commission in the days prior to their filing for bankruptcy. What is

the common denominator in all of these situations? Why do you think the relevant agencies

failed to perform their duties in each case? Looking at the freeze-up of markets that tends to

follow such events, what cause of market failure is indicated?

Lesson 75 – The Global Financial Crisis of 2008-2011 – Part Four – The Big Picture Going Forward

So, to sum up, in the early 1980s the actions of Carter and Volcker restored confidence in the US dollar

(and by extension, the US economy), for a while we saw the following virtuous circle:

High interest rates beat inflation

leading to...

...encouraged deregulated banks to develop ...increased confidence in the US

more financial products to offer investors dollar and US financial markets,

and to take more risks to boost their profits, leading to lower interest rates

which... which...

...encouraged Americans and foreigners

to borrow and invest ever greater

amounts in financial markets, which...

However, over time, as the US financial sector became more and more powerful, two things happened.

First, it became overconfident and dabbled in increasingly complicated and risky trades (often involving

derivatives and using increased debt to provide leverage) to boost profits and investor returns.

Secondly, it began to have more and more influence over the US government. As the profitability of the

financial sector grew, so too did its ability to make financial contributions to politicians for their election

campaigns. These two trends put together resulted in the following vicious cycle becoming well-

entrenched during the Clinton administration:

...making them increasingly reckless, An increasingly profitable and well-

but also more profitable and powerful, connected financial services industry

and therefore able to continue to... (banks, investment banks, brokers and

insurance companies) can...

...increasing their profits in good times ...lobby gov’t for less regulation of the

(and minimizing their losses in bad times, industry (and for bailouts and/or

such as the Peso crisis, the popping of lower interest rates when faced with

the dotcom bubble etc.)... losses)...

The lobbying pressure the financial industry was able to exert upon the Federal Reserve, the US

Treasury, and regulators led to increasingly poor capital allocation. Since 2001, the Federal Reserve in

particular has become little more than a tool of the financial industry (which should not be a surprise as

it is, despite its apparently governmental name, wholly owned the private banks it is charged with

overseeing). While the Federal Reserve’s primary job, as understood well by Paul Volcker, is to guard

against inflation, over the years, as memories of the 1970s have abated, it has become more and more

concerned with keeping asset bubbles inflated for the benefit of the financial sector. To allow the large

investment banks and insurance companies to avoid bankruptcy the Fed has lent vast amounts of

money and kept interest rates near zero since 2008. However, as we learned when we first looked at the

business cycle in lesson 42, bankruptcy serves a useful function, as it allows debts to be cleared and

assets to find alternative uses, resulting in redirected sustained growth.

The situation described above is not really that surprising, as it has been seen in many other countries in

the past (Indonesia and South Korea in 1997, for instance). In an excellent article published in the

Atlantic Magazine in May 2009 entitled “The Quiet Coup”, Simon Johnson, an ex-chief economist with

the IMF, told how the situation facing the US in the fall of 2008 reminded him of the crises he had seen

in emerging economies whose governments had been effectively captured by special interests who, in

order to protect their privileges actively block necessary reform. In the article, Johnson says how, in

order to gain access to needed bailout money, the IMF would insist upon reforms meant to break up the

cozy relationships between well-connected businessmen and the government. These reforms were

always fiercely resisted until it was made clear that the alternative was complete chaos.

However, compared to crony capitalism in, say, Indonesia, the capture of the US government by the

financial industry is much more serious for two reasons. First, the US is the world’s largest economy and

the US dollar remains the global reserve currency (This latter role has, in fact, allowed the crisis to grow

to its current proportions as for some time the US has been allowed to spend more than they earn as

foreigners have been willing to accept dollars in exchange for their goods to use as reserves or to use in

trade with other countries). A collapse in the value of the US dollar (similar to the collapse in the values

of the Thai baht and Indonesian rupiah during the Asian financial crisis of 1997) would lead to chaos not

just in the US but around the world as governments would see their reserves dwindle in value,

commodity prices (which are usually priced in dollars) skyrocket, and trade flows wither.

Second, while emerging economies have, in the past, been able to restore confidence with IMF (ie US)

prescribed reforms and assistance in the form of dollars, obviously this cannot be the case for the US

itself. The special privilege of being the centre of the world financial system carries with it a

responsibility to manage economic affairs with extreme prudence, because if you get things wrong,

there is no organization or nation above you capable of bailing you out. That is why the wrenching

recession of 1981 was necessary – the US had to show leadership and accept immense macroeconomic

pain in order to restore the global economy to health. However, while in the 1970s the irresponsibility

that had led to the crisis had been governmental (ie the desire of the Johnson and Nixon governments

to engage in a costly war in Vietnam without raising taxes), and could therefore be reversed with a

change in governmental priorities, today’s problems, being caused mainly by an out-of-control financial

industry, may be harder to address. The big investment banks (like Goldman Sachs) may not care about

the damage that a collapse in the dollar would cause the global economy so long as they can profit from

the volatility, as was the case in past emerging market crises. Here again, the experience from the Asian

financial crisis is instructive – in some ways the emerging market crises of the past 15 years can be

viewed as ‘trial runs’ for the take down of the US economy, which is indisputably the world’s fattest

prize. The first step in all of the emerging market crises was to force the deregulation of the financial

sector to allow greater participation by foreign banks. The second step was for these foreign banks to

flood the country with loans, which is easy as people usually optimistic and eager to borrow to build

businesses and homes. The third step was to engineer a financial crisis that would lead to a collapse in

the currency and asset prices (and widespread misery). The last step was for the foreign banks to buy

valuable companies, real estate and other assets cheaply in the immediate aftermath of the crisis, often

after having wrung further concessions out of the government to make them less subject to regulation.

What is important to note here is that there is no need for any sort of conspiracy for this to happen, but

rather that there are incentives at every stage that will cause profit and bonus-seeking bankers to act in

certain ways, especially bankers who have become accustomed to moral hazard. Bankers make

commissions on loans given, not on loans withheld, so in a deregulated environment where possibly the

loans will be sold onwards (much like housing loans were securitized in the US during the housing

bubble) they will try to lend as much money as possible to borrowers. Almost inevitably too much will

be lent as it is in our human nature to borrow more than we can afford to repay. Thus, a crisis is

inevitable. In the aftermath of a crisis, similarly, the incentive to buy valuable assets at knock-down

prices is similarly irresistible. What the various crises do suggest is that in the absence of strict

regulation, the financial sector has shown itself either incapable or unwilling to allocate capital

prudently. Instead, what the sector has given us is a succession of ever growing asset bubbles (emerging

markets, technology, housing) and consequent financial crises.

So, where do we go from here? Unlike in emerging markets that suffered from crony capitalism (where

certain businesses and the government worked for their own mutual benefit, at the expense of the

nation as a whole) where well-connected people would flee to the safety of the dollar, and thus

precipitate a currency crisis that would bring in the IMF and structural reform, in this case there is no

place for people to go and no organization or institution that can be called upon to impose reforms. As a

result, what we are likely to see is more of the same – an increase in the money supply to support more

bailouts and a steady rise in inflation, which may play out in one of two ways.

Most optimistically, if higher inflation results in a rise in asset, and in particular housing prices, the crisis

could pass. Higher housing prices would lead to fewer people walking away from homes that are worth

less than is owed on them, which would in turn lead to a fall in the number of homes for sale by banks

which would further support prices. Higher prices would also lead to people feeling richer and spending

money again, which would ease unemployment. Lastly, higher home prices and more robust

employment figures would lead to increased tax revenue and lower government spending and would

reduce the risk of governments defaulting on their obligations (ie the Greek crisis). With asset prices and

nominal GDP both rising and the debt to GDP ratio falling, confidence would return and with it economic

growth. A desperate desire to create and protect a narrative of growth and recovery (even if based on

lies) to create such confidence may help explain the manner in which MF Global was made bankrupt.

More pessimistically, without reforms, increased money creation by the Federal Reserve will just lead to

an environment more subject to moral hazard and therefore more mal-investment and speculation by

the financial sector. One commentator, Max Keiser, has compared the current monetary regime to a

municipal water system with a broken mains pipe. While businesses and homeowners need money to

support asset prices, banks in the US are not lending, despite their having received trillions of dollars

from the Fed to do so. Instead, banks are hoarding the money to cover the losses they sustained in the

past (but have not revealed, for fear of being recognized as insolvent) or are using the money to

speculate in commodities, which has resulted in higher prices for food and fuel. So, while the pumping

station (the Fed) is pumping money into the system, none of it is reaching people’s homes (households

and businesses). Instead, it is leaking out of the mains (the banking system) before it can reach homes

and is causing the streets to flood (price inflation).

Eventually, though, if inflation rises high enough to be a political problem (and it has a history of doing

so – nothing brings crowds onto the street more assuredly than rising food prices), governments will

have to act to arrest it, but will face determined opposition from a financial sector that has become used

to unlimited money at zero interest. In the end, those institutions that have been prudent and are

solvent will survive, while those that have not will go bankrupt. These bankruptcies will lead to huge

losses for many, as the bankrupt will be rendered unable to honour their own debts to others. This

process of reducing the quantity of financial assets/debts relative to the monetary base or income of an

economy is called deleveraging. While it sounds awful, the alternative is worse.

The experience of Japan since 1990 is instructive in this regard. In the 1980s Japan experienced a stock

market and housing bubble the likes of which the world has never seen. At one point, the grounds of the

Imperial Palace in Tokyo were judged to be more valuable than all of the commercial real estate in

Canada! When the bubble burst, though, the Japanese government and large corporations and financial

institutions did not write off bad debts and let insolvent firms go bankrupt. Instead, in order to avoid

deleveraging, they pursued a policy of ultra-low interest rates which has led to over 20 years of mils

deflation and low growth. The ‘zombie banks’ continue to exist, taking resources that would be better

employed by new firms and entrepreneurs, to the detriment of the entire Japanese economy. As there

has been next to no growth for 20 years, the Japanese government has continued to spend money on

stimulus measures to support income and employment, so that now Japan’s debt to GDP ratio is at an

all-time high. However, despite having ultra-low interest rates for 20 years, housing prices have not

risen. Japan has suffered economic stagnation for an entire generation due to its unwillingness to let

members of its governmental and corporate elite/oligarchy face the reality of failure.

In the end, avoiding such scenarios is why we employ markets. Free markets are good at establishing

market-clearing prices and at allocating resources accordingly. They uncover the truth. While it makes

sense for central banks to intervene in financial markets occasionally to provide liquidity during panics, it

makes no sense for them to intervene in order to prop up insolvent institutions indefinitely. This is

especially so if in order to do so one of the most important prices in the economy, the interest rate, has

to be manipulated lower, discouraging savings and encouraging those who have borrowed and wasted

the most capital in the past to continue to waste it with even more abandon in the future.

Exercise 75

1. Define:

a) CRONY CAPITALISM

b) DELEVERAGING

2. How can the statements “people are reckless and don’t know when to stop” and “give a man

enough rope, and he will hang himself” be applied to the events leading up to the global

financial crisis?

3. Thinking of the statements above, do you think that people in the financial services industry

deliberately set out to inflate asset price bubbles (like the dotcom or housing bubble)?

4. The “Occupy Wall Street” movement of the fall of 2011 listed three demands just before they

were removed from the park they were occupying in New York. They were:

a) Get the money out of politics.

b) Reinstate the Glass-Steagal act (which had separated investment banking from retail banking

from 1933 until 1999 and which had introduced deposit insurance for retail bank accounts).

c) Draft laws against the little-known loophole that currently allows members of Congress to

pass legislation affecting Delaware-based corporations in which they themselves are investors.

How would these measures make the financial system more stable? Do some research on the

Glass-Steagal act before you answer.

5. In the lesson, I have outlined three possible scenarios – money creation leading to asset price

inflation and normalcy, money creation leading to price inflation and an anti-inflationary

response a la Volcker, and money creation enabling stagnation a la Japan. I have left out the

most horrifying possibility, which is money creation leading to hyperinflation. Explain how this

could occur and why it would be the worst of all outcomes.

6. Were rising prices for food and fuel a factor in the ‘Arab Spring’ protests in Tunisia, Egypt, and

Syria and other countries in the Middle East? If so, what is the connection between these

protests and the financial crisis and associated bailouts?